Thursday, January 31, 2013

What's driving the rally in crude oil?

US crude oil prices have been moving up for nearly two months now. There are a number of possible explanations for this strength in crude, including ongoing Mideast unrest, expectations of higher demand from China, and of course the QE-driven "risk-on" trade.

MarketWatch: - Those include improving economic data, rising Mideast tensions, changing U.S. oil market fundamentals — with greater oil-export capacity out of Cushing, Okla., and the closure of a New Jersey refinery — and an increasing number of speculative hedge-fund net “long” market positions, or bets that oil prices will rise, he said.

March-2013 WTI contract (source: barchart)

But two recent developments make this rally particularly unusual.

1. US crude oil market is very well supplied. Inventories are materially above their the 5-year range.

Source: EIA

2. While some economists are talking about improved GDP growth in the US, the data so far is showing something quite different.

Near-term growth expectations in the US remain modest, particularly given the expiry of the payroll tax cut. Normally, slow economic growth and record supplies should limit a rally in energy prices. But these are not normal times and two other economic factors have taken center stage.

1. US monetary base hit a record last week as the Fed's asset purchase program goes into full swing. This is contributing to the "risk-on" trade.

2. And the US dollar has weakened in response, creating a positive backdrop for commodities.

US Dollar Index (DXY) (source: MarketWatch)

Yes, Mideast tensions and expectations of higher demand from Asia certainly contribute to this rise in oil prices. But absent major international supply disruptions, it will be the US monetary expansion and dollar weakness that will push crude higher - in spite of relatively weak economic fundamentals and a well supplied marketplace.